Classroom Newsletter: Peer-to-Peer Lending

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PAGE ONE Economics Peer to Peer Lending Katherine Ren Economic Education Intern GLOSSARY Annual percentage rate APR The percentage cost of credit on an annual basis and the total cost of credit to the consumer APR combines the interest paid over the life of the loan and all fees that are paid up front Credit report A loan and bill payment history kept by a credit bureau and used by financial institutions and other potential creditors to determine the likelihood that a future debt will be repaid Credit reporting bureau An organization that compiles credit information on individuals and businesses and makes it available to businesses for a fee Credit score A number based on information in a credit report which indicates a person s credit risk Interest rate The percentage of the amount of a loan that is charged for a loan Also the percentage paid on a savings account Liability money owed debt Microloan A small short term loan at low interest often used by self employed individuals or entrepreneurs for start up expenses inventory or equipment Soft inquiry Any check of a person s credit report that occurs when the person s credit is not being reviewed by a prospective lender Examples include inquiries as part of a background check a person checking his or her own score and checks by a financial institution with which a person already does business Some debts are fun when you are acquiring them but none are fun when you set about retiring them Ogden Nash American poet If you have ever taken a personal finance class you likely remember that the teacher emphasized the importance of maintaining a good credit score The teacher might have said that a good credit score gives you access to loans and credit cards with comparatively lower interest rates In addition you were likely warned of the consequences of a bad credit score and the potential dangers of easy access payday loans that offer cash at an annual percentage rate APR as high as 400 percent 1 As the terms FICO score interest rate and loans were thrown around in class perhaps it wasn t long until you found yourself wondering about your own credit score and its implications So what does a Fair Isaac Corporation FICO score tell lenders What s a good credit score and how does it affect the interest rate you ll pay How is traditional lending different from other types of lending And if payday loans are risky are there other alternatives to traditional lending Traditional Lending and Credit Scores When creditors consider making a loan they look at the borrower s credit score to assess that person s ability and willingness to make payments on time While an individual s credit score is not the sole factor affecting a credit application the credit score influences not only the amount a lender will provide but also the terms of the loan such as the interest rate One of the most common scoring techniques used by 90 percent of top lenders is the FICO score A base FICO score ranging from 300 to 850 is generated by considering a combination of an individual s information see the boxed insert As with most scoring methods a higher score is better the premise is that the higher the score the less risk posed to lenders 2 In addition to reviewing the FICO score the lender also carefully reviews the borrower s credit report a summary of the individual s payment history The three major credit reporting bureaus Experian TransUnion November 2015 Federal Reserve Bank of St Louis research stlouisfed org PAGE ONE Economics Determining a Credit Score What type of information is used to determine your credit score FICO uses the following information to generate credit scores Payment history Length of payment history Types of credit in use New credit accounts Current liabilities Scores range from 300 to 850 In general FICO credit levels fall into the following categories Poor credit Subprime Acceptable credit Good credit Excellent credit 1 Category ranges vary by creditor If you apply for a loan a loan officer from one institution may consider a FICO score of 680 to be in the good range while a loan officer from another institution may consider it only average The ranges shown above are from Credit org See Lamb Lori What Is a Good Credit Score Personal Finance News and Advice blog January http credit org blog what is a good credit scoreinfographic and Equifax collect information from banks credit card companies finance companies and other lenders to generate credit reports In fact the FICO score and the credit report go hand in hand in determining the creditworthiness of a loan applicant Peer to Peer Lending An Alternative Peer to peer lending is a relatively new method for obtaining credit Similar to microloans and crowdfunding resources peer to peer lending started as an avenue for impoverished borrowers to access loans without collateral Sites such as Kiva connected donors of the developed world to entrepreneurs in the developing world However the concept has since evolved to serve as a credit opportunity for individuals in the developed world as well Sites such as Lending Club and Prosper connect individual investors to borrowers who may not be able to obtain loans through traditional avenues These sites provide mainly debt consolidation loans credit card payoff loans and small business loans 3 How Federal Reserve Bank of St Louis research stlouisfed org 2 ever borrowers are not limited to these uses and may apply for loans to cover a wide range of needs such as car loans Aside from providing high risk borrowers with potential credit a couple of key characteristics differentiate peerto peer lending from traditional lending Perhaps the greatest difference is that peer to peer lending sites offer loans that are directly backed by investors as opposed to financial institutions The majority of peer to peer loans are funded by many investors not just one investor Depending on the borrower s payment history loans can be received in as little as one business day and usually have a payoff expectation of about 36 months In addition to providing a FICO score borrowers have the option to share private information in their profiles and are able to receive endorsements from other users to increase their credibility as a borrower As with traditional lending methods an individual s FICO score and debt rating factor into determining the interest rate of a peer to peer loan request Borrowers are not required to submit collateral and thus the loans are unsecured In addition the sites charge borrowers in the form of origination or closing fees that range from 0 5 to 5 percent of the value of the loan 4 The average peer to peer borrower has a FICO score of about 700 and is granted a loan with an interest rate ranging from 8 67 to 13 5 percent However some investors are willing to accept riskier borrowers with credit scores close to the minimum of 630 and offer to fund loans at APRs of more than 30 percent Thus peerto peer sites can serve as credit opportunities for those who are turned down by traditional lending institutions Likewise peer to peer loans are an alternative to payday loans that on average leave a borrower indebted for about 6 months with annual interest rates over 400 percent Furthermore while borrowers can receive loans ranging from 1 000 to it is important that they do not borrow more than necessary because they will be faced with not only higher interest rates but also higher origination or closing fees Finally it is wise for borrowers to apply to more than one peer to peer lender to compare the different rates offered Unlike traditional loan applications a peer to peer application does not negatively impact the borrower s credit score because it is classified as a soft inquiry 5 PAGE ONE Economics Peer to peer lending is a high risk high return option for investors While the yields tend to be higher than similar investment options such as certificates of deposit the loans are unsecured with no guarantee of repayment from either the borrower or a third party governmental agency However there are still strategic ways for investors to choose lending options such as diversifying their loan choices and watching trends As with stocks the best way for an investor to hedge risk is to invest in a range of borrowers Instead of fulfilling one borrower s entire loan it is wiser to partially fund a variety of loans from multiple borrowers of different risk levels Similarly it is often beneficial to gauge the credibility of a borrower by watching the investments of other investors For example if two borrowers of very different risk levels receive the same amount of money it is likely that an investor studied the higher risk borrower and determined that despite the high risk the borrower is in fact creditworthy As a result other lenders might consider this an indication of a good investment choice and add to the funding of the loan request This phenomenon is known as herding and refers to how investors often look to their peers to gain more information on the investment in this case more information on the borrower than a simple FICO score or other rating may reveal Federal Reserve Bank of St Louis research stlouisfed org 3 Conclusion Encouraged by the demands of consumer culture peerto peer lending has evolved tremendously over the past decade Borrower requirements are more accommodating than they are for traditional lending and interest rates are lower than they are for payday lending Sites such as Lending Club and Prosper offer loan alternatives for borrowers and investment opportunities for lenders What started out as a modest effort to allow more lowincome and credit risky borrowers to obtain loans has become a revolutionary tool connecting borrowers to investors n Notes 1 See Center for Responsible Lending Payday Loans http www responsiblelending org payday lending 2 See Fair Isaac Corporation What Is a FICO Score http www myfico com crediteducation articles and Kapoor Jack R Consumer Credit in Jack R Kapoor Les R Dlabay and Robert J Hughes Glencoe Business and Personal Finance Columbus OH McGraw Hill Education 2012 pp Zhang JuanJuan The Wisdom of Crowdfunding Federal Reserve Bank of Boston Communities Banking Winter pp 30 31 https www bostonfed org commdev c b 2013 Winter the wisdom of crowdfunding pdf and Hayes Adam What Is Microlending and How Does It Work Investopedia April http www investopedia com articles personalfinance 040715 what microlending and how does it work asp 4See Horymski Chris What You Need to Know About Lending Club and Prosper Consumer Reports January http www consumerreports org cro news 2015 01 what to know about lending club and prosper peer to peer index htm 5 Jones Sally Peer to Peer Lending Site Lending Club vs Prosper vs Upstart ASecureLife com March http www asecurelife com lending club vsprosper vs upstart Page One Economics and Page One Economics Focus on Finance provide informative accessible essays on current events in economics and personal finance as well as accompanying classroom editions and lesson plans The essays and lesson plans are published January through May and September through December Please visit our website and archives http research stlouisfed org pageone economics for more information and resources Federal Reserve Bank of St Louis Views expressed do not necessarily reflect official positions of the Federal Reserve System

OVERVIEW:
Where can borrowers get loans when banks and credit unions aren't an option? Maybe a low credit score, lack of collateral, or small loan amount don't fit with large lending sources. This newsletter describes a growing trend—peer-to-peer lending—as an alternative for borrowers and potential investment opportunity for lenders.

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